As financial planners, much of the work we do involves looking into the future and making assumptions for things like the returns on various types and classes of investments, the implications of changes in the tax code, and the impact of inflation in future customer spending.
The quality of the assumptions made for these factors can have a major impact on the quality and usefulness of a financial plan.
Inflation for most of the past two decades has been low, below 2%, so the recent dramatic increase in inflation surprised many.
There are several reasons for the recent rise in inflation. The recovery of the global (goods) supply chain after the covid shutdowns has been slower than expected. The war in Ukraine has led to supply cuts in both the global oil and food supply chains.
Another factor has been the high growth in the US money supply over the past two years driven by both the government’s large stimulus programs and the Federal Reserve’s monetary easing, both designed to support the recovery of the COVID.
Assumptions about inflation are an important element in building a financial plan, as inflation affects clients’ costs of living expenses, income streams such as Social Security, and also expected returns on investments When incorporating inflation assumptions into a financial plan, some planners use past inflation data, while others may use forecasts for future inflation rates. We believe that trying to forecast inflation is quite difficult, so we use the 50-year annual inflation rate. We believe this number is real, measurable and based on real data (currently it’s 3.9% by the way).
But what about a time like the present, where inflation has risen dramatically? It may be tempting to assume that inflation will remain at 8%, but a reasonable analysis would probably lead to the conclusion that this will not be the case. Therefore, using 8% as a long-term inflation rate in a financial plan would seem unwise, as it could dramatically overstate a client’s future expenses, and perhaps income as well. Also, how is inflation actually projected for the next 30, 40, or 50 years? It would be practically impossible.
Ultimately, the assumption of the future inflation rate is based on both historical data and the reasoned decision that, since we cannot actually forecast inflation, a number based on reality (ie, actual historical data) , is probably a more optimal choice and would also involve the minimum. risk The “risk” would be to use a number that is so far from a reasonable guess that it would significantly degrade the value of the plan. The same goes for investment performance assumptions: using irresponsible performance projections can do a lot of damage to the financial plan. As planners, a large part of our job is to analyze both historical and current data to make well-thought-out projections. , reasonable and reduce the risk of the plan as much as possible.
Robert Toomey, CFA/CFP, is vice president of research at SR Schill & Associates in Mercer Island.